Speeches/Testimony

September 20, 2000

NPRA testified before the House Government Reform Committee regarding U.S. energy concerns

Introduction

The National Petrochemical & Refiners Association (NPRA) represents virtually all of the refining industry, including large, independent and small refiners as well as petrochemical producers. Our members manufacture petrochemicals and the refined petroleum products needed to produce and transport America's goods and services. We understand your concern about the potential for price and supply problems this winter and in the future. And, we appreciate this opportunity to provide our perspective on energy markets and the impact of government policies on those markets. Thus, we will provide a snapshot of the current situation, but also discuss how we reached this point and what may lie ahead as a result of government policies currently under consideration.

Further, we will discuss the broader implications of the seemingly divergent goals of current US energy and environmental policy. In short, there is a disturbing lack of coordination between our energy and environmental policy objectives. The pursuit of a number of increasingly stringent environmental programs in a Apiecemeal" and uncoordinated fashion has stretched the US fuel refining and distribution system to its limit — resulting in greater potential for tighter supplies and increased market volatility.

While we do not wish to sound "alarmist," the experience in the Midwest this summer (and with heating oil supplies to the Northeast last winter) may be an omen for the future. As the Energy Information Administration (EIA) stated recently: AToday, the U.S. refinery system has little excess capacity, and the growth in the number of distinct gasoline types that must be delivered to different locations increases the potential for temporary supply disruptions and increased volatility."

And, EIA has specifically expressed concerns about the supply and cost of heating oil and natural gas for next winter. However, the good news is that there is still time for prudent action to build inventories and enhance supplies. And, there is time for reasoned consideration of both environmental and energy policies to ensure that future actions do not unnecessarily constrain energy supplies and threaten economic growth.

NPRA believes it is possible to enjoy reliable and affordable fuel supplies, while preserving, and improving upon, our environmental progress. However, this can only be achieved if energy and environmental policymaking is integrated and if the costs and benefits of new regulatory or legislative requirements are carefully weighed in the context of the impact on energy supplies.

This is particularly important now, given the host of new fuel requirements that could be imposed in the next 5-7 years — both by EPA and/or Congressional initiative. These include EPA's proposed far-reaching reductions in on-road diesel sulfur and legislative directives, such as S. 2962 (the Smith bill) which would phase out the use of certain oxygenates like MTBE, while mandating a tripling in the use of ethanol, and further constraining the manufacture of gasoline by capping aromatics and limiting other blendstocks that enhance fuel performance. At the same time, reinterpretations of existing policies, such as EPA's enforcement policy, may "change the rules mid-game," resulting in further regulation through enforcement rather through public rulemaking.

In short, as stated in our July testimony before the Senate Energy and Natural Resources Committee, the regulatory "blizzard" (see attachment) that NPRA has highlighted is in danger of creating "avalanche" conditions. And, to mix our metaphors a bit, some might even say that we are unknowingly headed for "The Perfect Storm."

Absent a comprehensive and integrated approach, energy policy will be just the de facto result of environmental policy. American consumers and our economy will suffer the consequences in terms of supply uncertainties, higher costs and lower economic growth.

The Current Outlook: Potential Exists for Continued Volatility in Energy Markets

The Energy Information Administration's (EIA) Short-Term Energy Outlook issued this month foresees continued tightness in heating oil, natural gas and electricity markets. Thus, there is potential for market volatility due to weather and operational difficulties in producing and/or distributing energy supplies. Barring unforeseen events, we should be able to make it through this winter without major disruptions. However, we must remain vigilant and do as much advance planning as possible, since in today's energy markets, small changes in supply or demand can have a significant impact on energy costs. Some actions have already been identified — for example, some refineries have deferred turnarounds scheduled for this fall and Colonial Pipeline has offered financial incentives to shippers committing to ship large volumes from the Gulf Coast to New York harbor in the fall and early winter.

With regard to distillate (heating oil and diesel fuel), inventories remain lower than average despite higher refinery output. In part, this may be due to a later than usual seasonal switch from maximizing gasoline production to maximizing distillate output (this may be part of the legacy of the gasoline supply challenges earlier this summer). According to American Petroleum Institute (API) statistics, refinery distillate output set a record for the month of August and was 8.4% higher than a year ago. At the same time, the overall US refinery utilization rate was almost 96% — in other words, refineries were running at, or very near, their operational maximum.

EIA's outlook states that:

"Now that the summer is nearly over, if the currently depressed level of distillate stocks continues into the heating season, the result would be a high level of price volatility for the distillate fuels this fall and winter. Last February, a period of very cold weather in the Northeast, in combination with notably low stocks of distillate fuel, led to heating oil and diesel fuel prices that averaged more than $2.00 per gallon in New England and other areas in the Northeast."

EIA expects continued buildup of inventories but cautions that "… the mid-winter levels are not likely to be sufficient to provide much of a cushion if severe weather conditions occur in the Northeast. Unless the winter in the Northeast is unusually mild and/or world oil prices collapse, substantial price strength gains for heating oil and diesel fuel are highly likely."

Similarly, with regard to natural gas, prices will be dependent on weather patterns and could be substantially higher. Here, too, inventories (i.e., working gas storage levels) are lower - 18% below year ago levels according to EIA. In part, EIA believes this is weather-related since unusually hot summer weather in Texas and California (states that consume large amounts of gas-generated electricity) have led to sub-par storage rates. And, demand has increased due to economic growth over the last 8 years and the increasing use of gas in power generation. EIA's outlook indicates that natural gas prices now are double this time last year and they project residential prices to be about 27% higher than last winter (October-March).

Electricity rates have also proved volatile this year due to higher fuel generation costs and generation capacity constraints. The latter has been affected in many areas by uncertainty about the scope and pace of electric restructuring following years of regulation. As recent experience in San Diego has demonstrated, electric markets can be quite volatile. And, a "wired" economy still relies on fuel via our electric outlets. However, prices can and do move in both directions and electricity costs were lower than normal in areas that had cooler summers such as the Northeast. Again, much depends on variables outside our control such as the weather.

In summary, we believe that fundamental changes in energy markets have increased the potential for supply constraints and price volatility. Due to these changes, it is even more important that any government policies affecting energy supplies be fully evaluated and care taken to avoid a rush to judgment that will later be regretted. Neither the last few weeks of a Congressional session nor the last few months of a Presidential term are optimal times for impromptu policymaking.

While potential for volatility exists in all energy sectors this winter, barring unforeseen circumstances, we should be able to handle the challenges we face. It is the challenges for the future that are more daunting. Before highlighting several of those concerns, we would like to provide some context on changes in energy markets that have led us to the current situation of greater supply and price volatility.

Fundamental Shifts in Energy Markets Have Occurred

Of course, we did not arrive at today's situation overnight. The forces that currently constrain energy supplies have been building over the last decade or two. And, many of these constraints arise from government programs which may have had laudable goals, but which have had consequences that were either ignored or unforeseen.

One fundamental change is that there no longer is a surplus in US refining capacity. No new refineries have been built since the early 1980s - in part because of the economics of the industry and in part because of constraints on construction. Since 1983, the number of US refineries has decreased from 231 refineries to 155 in 2000. Fortunately, despite the decline in the number of refineries, US refining capacity has not changed much (16.46 million barrels per day to 16.3) as refiners have tended to expand at existing sites, combining, for example, refinery equipment modifications for environmental programs with debottlenecking. Although this has helped stabilize supplies, it is not clear such a path can be followed in the future given EPA's propensity to reinterpret the rules pertaining to permitting and new source review.

Another fundamental concern is the impact of prolonged periods of low rates of return in the refining industry, especially when coupled with refinery ownership changes shifting some refineries from larger integrated companies to independent refiners. Even without considering this aspect, in a world where rates of return in the last decade for refineries averaged about 5% rivaling a passbook savings account, every refinery must stand alone to earn investment capital.

Within this type of economic climate, each refinery must be as efficient as possible and must tightly control costs. Some costs are unavoidable — such as the environmental requirements that the National Petroleum Council (NPC) estimated have exceeded the book value of the refinery assets themselves. More than $7 billion has been spent in the last decade to comply with environmental regulations. However, other costs can be controlled, hence the increased pressure to maintain adequate, but not excess, inventories. Thus, there has been a pronounced shift to lower inventories in recent years.

Another major change is the emergence of significant limitations on the fuel distribution system due to the large number of different environmental fuels that must be handled. Attached to this statement is a chart prepared by one of our member companies (Citgo) detailing the numerous types of summer gasoline that they produce. They currently must provide nine categories of gasoline to address varying state and federal programs. With three grades of gasoline per category that translates into 27 grades of gasoline. The ability to ship all these segregations via pipeline and the availability of separate storage tanks for each grade is becoming increasingly problematic.

And, this is before future requirements are factored in. Given EPA's disinclination to limit individual states' propensities to create their own fuel programs, additional constraints may be encountered. PIRINC's analysis of gasoline supply problems ("Gasoline 101: A Politically Explosive Topic") attributes the greater frequency of market volatility in recent times (e.g., California's price spikes in 1999 and this summer's price increases in the Midwest), at least in part, to states' tendencies to create fuel "islands." And, the Congressional Research Service made similar observations in their study of the Midwest gasoline market earlier this summer. Such isolation can have a marked effect if additional supplies that may be available nearby cannot be sent where they are most needed due to differing fuel specifications. Unfortunately, this trend could worsen if approaches such as that embodied in S. 2962 are adopted which would further encourage states to "go their own way."

In addition, the pace and scope of regulatory change is intensifying. EPA is setting fuel and vehicle emission requirements that simply may not be feasible or may only be achieved at the risk of much tighter energy supplies and greater price volatility. A prime example is the pending proposed rule for heavy duty diesel vehicles and on-road diesel fuel. Despite the serious concerns expressed by many industries and consumers of diesel fuel (see attachment), EPA seems determined to rush to finalize this rule despite the fact that they are moving much more quickly than the leadtime requirements mandated in the Clean Air Act.

New fuel and vehicle emission requirements are pushing the feasibility envelope. They also do not meet the test of cost-effectiveness. Further, the volume of fuel affected has grown substantially. For example, EPA's reformulated gasoline program only affects the fuel sold in the worst ozone nonattainment areas (about 25% of US gasoline), however the new requirements to substantially reduce sulfur in gasoline will apply to all gasoline nationwide, as is the case for the proposed on-road diesel fuel sulfur reduction.

And, the timing of these fuel programs is significant. The stringent reductions in gasoline sulfur, the substantial reductions in diesel sulfur and the phasing out of MTBE all overlap. This raises serious concerns about the availability and cost of engineering and construction services, not to mention whether all the necessary permits could be obtained in order to meet these deadlines. The recent NPC report, "U.S. Petroleum Refining: Assuring the Adequacy and Affordability of Cleaner Fuels," strongly recommended that the effective date of the proposed diesel program be adjusted so that it does not overlap with the implementation of the gasoline sulfur program. The NPC study noted that: "The timing and size of the necessary refinery and distribution investments to reduce sulfur in gasoline and diesel, eliminate MTBE, and make other product specification changes such as reducing toxic emissions from vehicles are unprecedented in the petroleum industry." [Emphasis added] And, the NPC cautioned that "there will be an increased likelihood of localized supply disturbances as product quality specifications are tightened, particularly during the initial implementation of new specifications."

The scope of the refinery modifications needed to conform with these requirements raises another concern from a supply perspective, namely that more and more pieces of refinery equipment become essential to producing complying product. Thus, any operational problems that occur could affect larger volumes of the fuel produced at a refinery and the supply impact will be magnified in downstream fuel markets.

Another significant change is a steady growth in US product imports to meet demand. However, programs such as EPA's gasoline and diesel requirements would set different and more stringent standards, thus potentially cutting the US off from needed supplies in the event of a supply/demand imbalance.

Addiitonal Supply Concerns Could Surface in the Future

Several environmental programs currently being considered, or being reinterpreted by EPA, present substantial risk for future energy supply challenges. The three that we would like to highlight today are EPA's proposed rule for ultra low sulfur diesel fuel; S. 2962 (introduced by Senator Smith, R-NH) as reported out of the Senate Environment and Public Works Committee; and EPA's reinterpretation of their new source review permitting guidance.

With regard to diesel fuel, industry has committed to substantially reduce the sulfur level of on-road diesel (a 90% reduction from today's level). However, EPA has a different plan and wants an even larger reduction in sulfur content as well as harsh new emission controls on heavy duty vehicles. Engine manufacturers, such as Cummins, have pointed out that the technology to achieve those emission reductions is not yet available and may well prove infeasible. Refiners have questioned the cost-effectiveness of a 97% reduction in diesel sulfur levels, given the substantial impact it will have on fuel supplies.

A recent study by Charles River Associates, commissioned by API, has determined that the EPA proposal, when implemented, will result in a national average supply shortfall of 12% versus current supplies. However, the regional effects will vary — with the Rocky Mountain region facing a potential shortage of thirty seven percent! And, domestic diesel supplies will not be able to be supplemented by imports since the US will have a different fuel specification than Canada and Europe.

Moreover, the agricultural community, food marketers, trucking industry and even the Department of Defense have raised concerns about the availability and cost of diesel fuel. Furthermore, a number of serious questions have been raised about EPA's cost estimates. Cummins has indicated that their estimate of the potential engine costs is at least six times more than EPA's and that operating costs also will be higher. Indeed, there will be about a 5% fuel economy loss, thus increasing demand for diesel at a time that supplies will be reduced. Given the market volatility that has already been evidenced with much smaller shortfalls and the fundamental changes that have occurred in energy markets, proceeding with EPA's proposal without further analysis would seem to be a recipe for disaster.

We believe that the nation cannot afford to implement a program that will create diesel shortages. NPRA urges this committee to scrutinize EPA's proposal and require a third party such as the National Academy of Sciences to study this proposal's impact on energy supplies, agricultural uses, transportation and engine manufacturers before the rule is rushed to finalization. It is critical to remember that we have the time to do this right. Even if reductions in diesel fuel sulfur content were required in 2006 as proposed, the four years leadtime required by refiners means that we have another year to a year and a half to ensure that reductions will be made in a cost-effective manner without jeopardizing fuel supplies.

Another area of grave concern is the recent Congressional action in the Senate Environment and Public Works Committee to phase out MTBE use, but in combination with a substantial new mandate for ethanol and additional constraints on gasoline blending through further controls on toxics and an aromatic cap. This bill, S. 2962, would adversely affect gasoline supplies and their cost, and even further strain an already limited fuel distribution system. The bill would allow any area to opt into the more costly federal reformulated gasoline (in contrast to the Clean Air Act Amendments of 1990 that required that fuel only in the 9 worst ozone nonattainment areas). Additionally, states that are concerned about the higher evaporative emissions associated with ethanol use would have the option to rescind the volatility waiver on ethanol fuels used to meet the national ethanol mandate. Thus, fuel suppliers could encounter a scenario where one state keeps the waiver while an adjacent state rescinds it - effectively balkanizing the fuel distribution system. The coup de grace is that the bill would require a mandatory tripling of ethanol use by 2010. Refiners already use substantial volumes of ethanol and its use will grow more in the future. However, mandates usually stifle competition and tend to lead to less, not more, competitive markets.

Given the significant volatility witnessed this year in Midwest gasoline markets (markets incidentally that already use ethanol), it is not clear why such a policy should be pursued. Recent events in Europe have demonstrated that even consumers inured to high fuel costs can reach their limit, and we all know American consumers have never been shy about voicing their discontent with comparatively small increases in fuel costs. We urge this committee to stand firm on the crucial principle that sound energy policy can only be the result of deliberative analysis rather than simply being the "fallout" from incremental environmental decisionmaking.

This type of sound analysis and procedure is totally lacking from the third area that we highlight today, what we refer to as "regulation by enforcement." Through EPA's reinterpretation of its new source review guidance, the rules have been changed after the game has begun. And, make no mistake, this is no game but instead relates to the very serious issue of energy security and the future economic growth that can be attained. In short, it is an egregious abuse of regulatory power.

EPA has reinterpreted its rules covering modifications to existing facilities, in this case refineries, after those modifications have been completed and after a prolonged period. The effect will be to slow down future modifications at a time when the onslaught of regulatory requirements is accelerating and when energy markets will be ever more tightly constrained. The resultant inability to expand capacity at existing facilities will further limit fuel supplies as new refineries have not been built and seem unlikely to be built in the future. In addition, EPA has similarly challenged other energy producers, i.e., electric utilities, and pursued them for alleged noncompliance. In short, EPA is seeking to fine those who acted in good faith but who failed to comprehend the incomprehensible - EPA's reinterpretation after the fact.

Further, refiners will spend significant sums to simply meet EPA's information requests - funds that could be invested in the nation's energy future instead of in document requests. Our members make every effort to comply with highly complex and, often onerous regulatory requirements. They remain committed to environmental progress and full legal compliance. However, it is never fair to change the rules mid-game and impose retroactive penalties. We urge this committee to examine this highly questionable and abusive practice of "regulation by enforcement."

Summary

NPRA appreciates the interest of this Committee, and we want to work with you to find solutions to these problems. We believe that it is critically important that policymakers begin a review of our nation's energy policy and provide a realistic energy policy for the U.S. domestic refining industry and other stakeholders. We must recognize the fact that the refining industry and our nation's entire supply infrastructure is operating near its limit and will continue to do so for the foreseeable future. Little flexibility remains to respond to disruptions. Unfortunately, some disruptions may be unavoidable and may occur despite our best efforts to prevent them.

The refining industry has a strong commitment to improving the nation's environment, but we caution that environmental goals must be set in the context of our overall energy goals if we are to maintain our energy security. We believe, for example, that sulfur levels must be reduced in both gasoline and diesel. Refiners have offered reasonable and cost-effective programs to make these reductions. However, they have been totally ignored by EPA, despite our cautions about potentially severe product supply consequences. The pending EPA diesel sulfur proposal is a blueprint for reduced supplies of highway diesel and should not be made final without extensive revisions. Unfortunately, EPA seems determined to go forward with this radical and extreme proposal this year, and has ignored the concerns of the industry and numerous other stakeholders about its impact on supply. This indicates to us that we can expect "business as usual" with predictably adverse future impacts unless Congress or the courts intervene to balance environmental and energy supply concerns.